Liquidity and Leverage

Referee Finance Team

Liquidity and Leverage

Tobias Adrian and Hyun Song Shin

In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from financial intermediaries who adjust the size of their balance sheets.

The focus of this paper is on the reactions of the financial intermediaries to changes in net worth and the market wide consequences of such reactions.

The main objective of the study is:

a) To document the determinants of balance sheet size and leverage for the group of financial intermediaries that operate primarily through the capital markets. b) To pursue the aggregate consequences of such procyclical leverage, and document evidence that expansions and contractions of balance sheets have important asset pricing consequences through shifts in market-wide risk appetite.

The study also explores the role of value at risk (VaR) in explaining the banks’ balance sheet decisions. The empirical study examines the quarterly changes in the balance sheets of five large investment banks. The regression models examine the relationship between changes in leverage with respect to changes in total assets; repos and reverse repos and value at risk to equity.

If the financial intermediaries were passive and do not adjust their balance sheets to changes in net worth, then the leverage would fall when total assets rise. Change in leverage and change in balance sheet would then be negatively related.

The evidence points to a strongly positive relationship between changes in leverage and changes in balance sheet size. Financial intermediaries seem to adjust their balance sheets actively, and doing so in such a way that leverage is high during booms and low during busts. This procyclical leverage can be seen as a consequence of the active management of balance sheets by financial intermediaries who respond to changes in prices and measured risk. The margin of adjustment on the balance sheet is through repos and reverse repos (and other collateralized borrowing and lending).

The study find that the valueatrisk (VaR) disclosed by the banks is an important determinant of balance sheet stance, but also find evidence of an additional procyclical element in leverage that operates over and above that implied by their disclosed value-at-risk. The results suggest that changes in aggregate intermediary balance sheet size can forecast innovations in market-wide risk premiums as measured by the VIX index of implied volatility in the stock market. The empirical findings also suggest that funding liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries’ balance sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital.

The waxing and waning of balance sheets have a direct impact on asset prices through the ease with which traders, hedge funds and other users of credit can obtain funding for trades When balance sheets expand through the increased collateralized lending and borrowing by financial intermediaries, the newly released funding resources then chase available assets for purchase.